Intelligentguess

This is a post by guest author, KRG. KRG is a senior executive in the financial services industry in India. He heads the treasury function of a leading financial institution and prefers to identify himself solely by his initials. The post is his reflection on the measures announced during the presentation of India’s annual budget by the Finance Minister, P Chidambaram (PC).

I was told that a lot of people were expecting a populist budget; and one was kind of prepared for it. But as the budget speech progressed, I started getting a feeling that the underlying tone is not quite normal and certainly not expected of PC. I will list out the things that stood out for me:

-        Growth is given; our job is to make it is inclusive (the smug part…).

-        Futures in wheat and rice are banned (An expert committee will now review the future of commodity futures… FM says that FMC banned this and that he will go by expert recommendations… Already there are arguments on what caused the fall in some of the agri-prices; market men seem to suggest that the price action is in tune with delivery expectations while authorities claim credit through the ban…… Voila, we have a new control measure on inflation… ban futures and primary prices will fall. When they fall too much we can reintroduce trading again).

-        Fiscal deficit contained as per targets (but wait, this is only in percentage terms; actual numbers show slippage despite very strong tax collections mainly on account of non-plan expenditure…. And we thought that the reformist and clean PM/FM combine has started getting a hang on how to control expenditures especially the non-planned variety).

-        MAT made applicable for IT sector. Whatever happened to the Tax-holiday till 2009? Or is it something else?

-        ESOPs are now part of FBT. There seems to be lot of confusion on how this is going to be implemented. My view is that on the difference between option exercise price and Fair Market Value at the time of option exercise (FMV), the company will pay FBT and employee will pay capital gains tax on the difference between FMV and the sale price. Again, the principle that a capital asset will be taxed differentially seems little unpalatable. If the idea is that employee will pay capital gain on full amount (i.e. between sale price and exercise price) and company will separately pay FBT on the difference between FMV and exercise price, then this gets even more confusing. Tax a benefit which is being taxed separately anyways….We have new defining Fiscal Paradigms.  

-        Cement: This takes the cake…..; Dual taxation to control inflation… It is a separate and mute point that the prices actually went up. It is a separate point again that this opens up issues like what is the right cost, quality, margin etc. The more important point is why the logic cannot be extended to others. All manufacturing inflation can be nipped at the source. Lay down specific prices for all inputs as well. And introduce multi-layered taxation for excise and extend the concept to customs duty etc. Yet another defining Fiscal Paradigm that fits the ultra new inclusive-growth-oriented-anti-inflationary-yet-market-determined economic system. Sounds more like the return to command economy

It is quite possible that I got all this wrong or am seeing too much into too little and would therefore love to be corrected. Especially since the present PM/FM combine is easily the most market-friendly set-up that we have got so far and how we hate to lose them to some contrived and contorted economic and fiscal logic

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Data released by RBI shows that India’s forex reserves stood at USD 193 bn as on February 23, 2007. Forex reserves have been growing at a brisk pace over the last month or so (for which data has been made available). Additions to foreign currency assets (which comprise the bulk of the reserves – the remaining comprises gold holdings and IMF SDRs) during the last 4 weeks (for which data is available) is as below 

 The above comprises the bulk of additions to reserves since December 2006. Addition to reserves since December 2006 is now USD 15.86 bn while addition over the past year is USD 51.5 bn. 

Quite obviously, RBI has continued its furious purchases in the fx markets. This is corroborated by the rise in money market liquidity and the consequent fall in overnight rates. 

Significantly, the sharp rise in reserves has come in spite of a sharp sell off in the equity markets during the last two (one of which is the week for which the data pertains to).

 I continue to wonder – Where is all the money coming from?

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The Reserve Bank of India has announced significant and important changes to the manner in which it conducts liquidity management through its daily liquidity adjustment facility (LAF).

Key elements of the revised method are :

• Daily absorptions by RBI under reverse repo would be limited to INR 30 bn. In the current dispensation, the amount that RBI absorbs is limited only by the amount of securities (eligible for tender under reverse repo) held by it.

• Absorption of liquidity of an enduring nature would be carried out through the issuance of securities (Treasury Bills and longer maturity securities) under the market stabilization scheme (MSS).

• RBI would, subject to variations in liquidity, announce every Friday the possibility and the quantum of MSS issuances for the succeeding week.
  • In addition to this policy announcement RBI has also announced the schedule of MSS issuances for the week beginning March 5. It includes Treasury Bill issuances worth INR 25 bn and reissue of a 2 year government bond worth INR 60 bn.

A quick take on the revised measures leads me to the following opinion / conclusions

• The limit of INR 30 bn has been imposed only on absorption of liquidity and not on injection of liquidity. While current market conditions force RBI to mostly absorb liquidity, it remains to be seen if the limit is extended to conditions wherein RBI is forced to inject liquidity into the money markets

• Current absorption of liquidity by RBI is in the range of INR 200-250 bn on an average. Of this about 7 bn would be impounded as the increased cash reserve requirement kicks in on Saturday. RBI would therefore be left with the task of absorbing about 15-20 bn through its liquidity management operations.

• The current announced schedule of mopping up operations absorbs about INR 115 bn (30 bn daily + 85 bn under MSS). This leaves a surplus of about 100 to 125 bn for the market to absorb on its own. In the short term, therefore, we can expect overnight rates to moderate a bit.

• Moderation of overnight rates is probably not what the RBI wants under its current policy dispensation (which explicitly talks of withdrawal of accomodation). We can therefore expect more aggressive issuances under MSS in the coming weeks, unless liquidity conditions tighten in the natural course.
  • The past few days have seen significant selling by foreign investors in the capital markets. Repatriation of these monies could lead to a fall in market liquidity. Fiscal restraint could also lead to a moderation in surplus liquidity.

• One, possibly unintended, consequence of RBI’s move to limit the amount of daily absorption is that it would probably lose information on the direct estimate of “surplus liquidity”. The prior dispensation gave it (and the marketplace) a good (and fairly accurate) idea of the estimated surplus liquidity. However, we could still get an estimate of surplus liquidity by looking at the daily overnight lending/borrowing transactions by market participants. All deals struck at a “rate below the official repo rate” could possibly be clubbed under “surplus liquidity”.

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